MauledAgain

Prof. James Edward Maule's more than occasional commentary on tax law, legal education, the First Amendment, religion, and law generally, with sporadic attempts to connect all of this to genealogy, theology, music, model trains, and chocolate chip cookies. Copyright 2004-2012 James Edward Maule.

Monday, September 30, 2013

“Tax Us More!” Say Some Wealthy Pennsylvanians

Philadelphia’s public schools are in dire financial straits, to the point where closing schools and showing employees to the door won’t solve the problem. Though a variety of factors have contributed to the situation, one component of the deficit is a reduction in state funding. Those who understand the long-term view of cost benefit analysis realize that the so-called savings being implemented in Harrisburg for the benefit of corporations and wealthy individuals will be more than offset by a serious price ten, twenty, and even thirty years down the road. Why? Because failing to educate the next generation is a bad investment.

Last week, a letter was published by “a group of people in our 20s and 30s with inherited wealth and class privilege” advocating tax reforms for the benefit of the Philadelphia schools. Yes, they did write, “Tax us more!,” pointing out that “Wealthy individuals and corporations are not paying our fair share of taxes.” Whether the vast majority of their peers agree with them remains to be seen.

This group, however, also offered an very interesting argument against the claim that the additional funds available to the wealthy on account of tax cuts can be used for philanthropic purposes to accomplish what governments cannot do on account of revenue shortfalls. They explain that there is a huge difference between education and similar public endeavors being financed with tax money and those same activities being financed with private philanthropic funding. Funding financed with tax dollars is subject to public scrutiny, control, and input, whereas privately-funded alternatives, the existence of which is another cause of the public school system financial distress, contributes to the “root causes of inequality.” As they point out, “It weakens the democratic process.”

Those who signed the letter suggest that when the wealthy give away money, they feel they are making a difference, but by retaining the power to decide what gets funded, they “perpetuate the injustice we think we’re addressing.” Indeed, one of the great risks of the ever-increasing inequality that afflicts this country is that democracy is in danger of being replaced by oligarchy.

Another suggestion from this group deserves deep consideration. “Make policies that require businesses to respect people over profit. Until wealthy people’s means of making money are just, no amount of charitable philanthropy will cancel out the exploitation that initially created the wealth.”

One of their sentences caught my eye. I like it. “Require us to opt in to the public sphere, not choose to pay to set our lives apart.” The days of nobles in castles and peasants on the land, of plantation owners on porches and slaves in the field, of wealthy in gated communities and poor in slums need to be part of history taught as reminders of why democracy matters and how fragile it is. Those days ought not be present-day conditions of society.

Friday, September 27, 2013

Tax Argument Cleverness Can Be Too Clever

A recent Tax Court case, Cahill v. Comr., T.C. Memo 2013-220, illustrates why cleverness alone not only can be insufficient to win the argument but also why it can backfire. The taxpayer attempted to demonstrate that a payment from a partnership was a loan, whereas the IRS treated it as a guaranteed payment. The taxpayer rested his argument on the claim that he was not a partner in the partnership and thus could not be the recipient of a guaranteed payment.

The taxpayer attempted to prove that he was not a partner in the partnership by showing that he did not sign the partnership’s amended and revised operating agreement. The Tax Court explained that determining whether a partnership exists and whether a person is a partner in a partnership are questions of fact, resolving the issue of whether “the parties intended to join together in good faith with a valid business purpose in the present conduct of an enterprise.” To answer the question, the court noted the importance of the agreement between the parties, the conduct of the parties, the parties’ statements, testimony from disinterested persons, the relationship of the parties, the abilities and capital contributions of the parties, the actual control of income, and the purposes for which the income is used.

The Court focused on a variety of facts. The taxpayer and the partnership acted as though he was a partner. The taxpayer testified that he contacted the other partners because he wanted to pool his resources and develop business jointly with them. The taxpayer entered into a memorandum of agreement and a revenue sharing agreement with the partnership, and both agreements set forth a mechanism for letting the taxpayer share in the profits. Both agreements also provided that the partnership would issue a Form 1099-MISC or a Schedule K-1 to the taxpayer with respect to any money paid to the taxpayer, and there was nothing in the record indicating that the taxpayer objected to receiving a Schedule K-1 on the grounds he was not a partner. In addition, the revenue sharing agreement referred to the taxpayer and the other partners as “producers,” thus putting the taxpayer on the same footing as the other partners with respect to revenue sharing. One of the other partners testified that they intended for the taxpayer to be a partner in the business. After the taxpayer joined the partnership, it changed its name so that the taxpayer could tell clients that the name of the partnership included the first letter of his surname, and there was nothing in the record indicating that the taxpayer objected to this change of partnership name to include a reference to him.

Though it can be considered clever to argue that one is not a partner because one has not signed a revised partnership agreement, the law makes it clear that there is much more to determining whether someone is a partner than the mere appearance of the words of the person’s name in signature form on an agreement. Actions, not surprisingly, speak much louder than do words. If a person acts like a partner, is held out to the world as a partner, and is treated as a partner without objection, that person ought not claim that he is not a partner.

Wednesday, September 25, 2013

Federal Supervision of State User Fees: Another Example of Its Necessity

The movement attempting to reduce or eliminate federal taxation and to reduce or eliminate the federal government presents, as one of its justifications, the allegedly overbearing presence of the federal government in matters that ought to be left to state governments. The fallacy of this position is demonstrated by the failure of state governments to comply with fundamental principles of fairness and public fiduciary duties when handling or ignoring important public issues. Recently, an example of why states cannot be trusted to get it right has moved back into the spotlight.

Recently, the Government Accounting Office issued a report, INTERSTATE COMPACTS: Transparency and Oversight of Bi-State Tolling Authorities Could Be Enhanced, and presented it to the Chair of the United States Senate’s Committee on Commerce, Science and Transportation. The report concluded, not surprisingly, that multi-state toll agencies have not been sufficiently accountable to those paying the tolls, and are not complying with a federal law that requires the tolls to be “just and reasonable.” The reason for the non-compliance is that the federal government is not enforcing the requirement. The lack of enforcement stems from the fact that Congress repealed the authority of federal agencies to enforce the requirement. It doesn’t take a degree in political science, or the brain of a rocket scientist, to figure out that if funding and authority for enforcement of a requirement is eliminated, the requirement has no meaning. Is it any wonder that the DRPA has gone on a spending spree with tolls, and has raised those tolls on several occasions to finance the spending that is not related to the facilities under its care? Relying on the states to correct the problem has proven to be impractical, as entrenched private sector interests have blocked attempts at reform. The situation is a classic example of why federal intervention is necessary in order to advance justice.

The motorists who object to repeated toll increases used to enrich private sector enterprises, rather than being used to care for the tolled facilities, might consider how they have ended up in the objectionable situation in which they find themselves. Is it possible that they would have been spared these financial burdens had federal oversight of multi-state toll facility agencies been left in place? Is it possible that cries for deregulation, translated as letting the private sector run roughshod over the public, were not the pathways to individual freedom for all as touted, but were devices to assist in the financial oppression of the middle class and the enrichment of the well-connected financial elite? Those who claim that “the federal government is not your friend” fail to point out that “the state governments and the multi-state agencies under their supervision are our friends, not yours.” If states continue to fail in their fiduciary responsibilities, it’s time to restore federal agency authority, and funding, to rectify the injustices being done to motorists.

Monday, September 23, 2013

More Proof the Tax Law is Too Complex?

With the tax law drowning in credits and deductions, it’s no wonder that the IRS has characterized two deductions as credits. On its Credits and Deductions page, the IRS lists, under credits, the “Business Depreciation Credit” and the “Casualty, Disaster & Theft Losses Credit.” Clicking the link for these two items brings the reader to pages that describe the depreciation deduction and the deductions for casualty, disaster, and theft losses.

When I taught the basic federal income tax course, one of the concepts in the group of principles that a student needed to master in order to earn a passing grade was the difference between a deduction and a credit. For the curious, others included the difference between an exclusion and a deduction, the difference between a personal exemption and a dependency exemption, the status of the standard deduction as an alternative to, rather than supplement to, itemized deductions, the difference between income and gross income, the difference between gross income and adjusted gross income, and some other similar concepts.

Thanks to a sharp-eyed reader who brought the IRS page to my attention. When even the agency charged with administering the tax law is confused, that’s a clear signal to the Congress that it ought to turn its attention to constructive endeavors, such as repairing the tax law. But I suspect that’s asking just a bit too much of our legislators.

Friday, September 20, 2013

Deductions Require Evidence and a Bit of Care

A recent Tax Court decision, Linzy v. Comr., T.C. Memo 2013-219, grabbed my attention for two reasons. One is substantive, the other is procedural.

The first aspect of the case that caught my eye was the attempt of a tax return preparer to deduct a vacation as a business expense. She explained that she operated her tax return business from her home, and explained that “living in her neighborhood was stressful and that she felt harassed by her clients who would call her home at any hour.” Accordingly, she concluded that she needed to travel “just to get rest so that . . . [she] could function.” The Court, not surprisingly, denied the deduction, characterizing the cost of the vacation as a personal expense. The decision is consistent with the holdings that the cost of food cannot be made deductible by arguing the lack of food prevents a person from engaging in any activities, including income-producing activities.

The second aspect of the case that caught my eye was the outcome with respect to the taxpayer’s home office deduction. The taxpayer claimed a home-office deduction based on one-half of her residence expenses, explaining that she operated her tax return business on the entire first floor of her two-story residence. The Court upheld the IRS disallowance of the deduction on the ground that the taxpayer had not proven that one-half was the appropriate fraction. Two years ago, in Linzy v. Comr., T.C. Memo 2011-264, in a case involving the same taxpayer – though with the name Joyce Ann Linzy rather than Joyce A. Linzy as in the recent decision – the taxpayer was permitted to deduct one-third of the expenses for the building in which she lived. Though the facts are unclear, it appears that the building used in the earlier case was a different building, because it is described as having a basement in addition to two floors and as having an apartment on each of those two floors. It appears, though this is an educated guess, that the IRS and the taxpayer stipulated as to the usage of the building in the earlier case, whereas in the recent case no such stipulation appears. Presumably, in the earlier case, the taxpayer provided sufficient evidence to the IRS to obtain its agreement to the stipulation, and thus the question is why, knowing how to generate a stipulation, the taxpayer did not provide equivalent evidence in the more recent case. The question is particularly interesting because the taxpayer is a tax return preparer.

The taxpayer’s argument with respect to the first point, though unsuccessful, reveals some degree of cleverness. Why that cleverness did not carry over to the procuring of a stipulation with respect to the home office deduction remains a mystery.

This time, Vos Savant took on a question about selling an encumbered residence. The questioner described a situation in which two people owned a home, presumably equally. The home is worth $200,000 “with $10,000 in equity.” Owner #1 will retain title to the house, and offers Owner #2 $5,000. Owner #2 wants $100,000. The questioner asked, “What’s the fairest thing to do?”

It is unclear from the question whether Owner #2 will remain liable on the mortgage loan, or whether Owner #1 will assume responsibility for repaying the loan. Vos Savant did not take that factor into account. Instead, she pointed out that a “key factor” to consider was the amount remaining on the loan. She suggested that, “Maybe the house was bought when it was worth half as much. Or twice as much!” She then presented two examples. In the first, she hypothecates that the house was purchased for $150,000, with $140,000 “left on the loan.” Thus, she concludes that the co-owners “would gain $60,000” if they sold the house for $200,000, requiring Owner #1 to pay $30,000 to Owner #2. In the second example, she hypothecates that the house was purchased for $250,000, with $240,000 remaining on the loan. She concludes that the co-owners would lose $40,000 if they sold the house for $200,000, requiring Owner #2 to pay $20,000 to Owner #1.

Here’s the problem. The facts presented by the questioner make it clear that the balance on the loan – whether the unpaid portion of the loan taken out at the time of the purchase or a subsequent loan, or a combination – is $190,000. The house is worth $200,000, the equity is $10,000, and thus the loan balance is $190,000. The loan balance is not $140,000, and the loan balance is not $240,000. Thus, the examples Vos Savant provides don’t answer the question. They answer questions not asked about situations not confronting the questioner.

Here is the answer that I would have provided. If Owner #1, with the consent of the lender, assumes full responsibility for the loan, Owner #2 should be paid $5,000 by Owner #1. That is the value of Owner #2’s interest in the residence. If, on the other hand, Owner #2 is required by the creditor to remain liable on the loan, then Owner #1 should pay $5,000 to Owner #2, plus any amounts paid by Owner #2 to the lender should be reimbursed by Owner #1 because Owner #1 is taking full ownership of the residence.

To demonstrate why this is correct, consider several possibilities of how the owners ended up in this situation. Assume that they purchased the residence for $200,000, each paying $5,000 in cash, and together borrowing the $190,000. Assume further that the residence did not change in value. Owner #2 invested $5,000, and would be getting that $5,000 from Owner #1, and thus is whole. Or suppose that they purchased the residence for $100,000, each paying $5,000 in cash, and together borrowing $90,000. Assume further that the residence increased in value to $200,000, and that the owners jointly borrowed another $100,000 and split the proceeds. Economically, the owners together have a gain of $100,000, the residence having been purchased for $100,000 and having increased in value to $200,000, and thus each owner should emerge from the transaction with their $55,000, the sum of the $5,000 that was originally invested plus $50,000, one-half of the gain. If Owner #1 pays $5,000 to Owner #2, Owner #2 ends up with $55,000, with $50,000 coming from the proceeds of the second mortgage loan and $5,000 coming from Owner #1.

No matter how one slices it or how many factual variations are constructed – of course, without changing the original facts that at the present time the equity is $10,000 and the loan balance is $190,000 – Owner #2 would incur a windfall if paid $100,000 by Owner #1. There are no factual variations – putting aside gifts from Owner #1 to Owner #2, something beyond the scope of the question – that justifies Owner #2 walking away with $100,000, or $30,000, or that justifies Owner #2 paying anything to Owner #1.

I concluded Getting Smart About Tax Questions with this comment, “Though how smart a person Marilyn vos Savant is continues to be debated, one thing is certain. When it comes to income taxation, she has more to learn.” I conclude this post with “Though how smart a person Marilyn vos Savant is continues to be debated, one thing is certain. When it comes to residential financing, she has more to learn.”

Monday, September 16, 2013

Another Look at Highway Privatization

Several years ago, in Are Private Tolls More Efficient Than Public Tolls?, I described why it is wrong to put public assets into the hands of private sector entrepreneurs so that they can enrich themselves at public expense, and how attempts in the distant past and the recent past to provide travel access through private highways failed. I explained, citing earlier posts, how privatization of public highways works for the entrepreneur only by disadvantaging the public. Aside from raising tolls, the entrepreneurs play all sorts of political games to force motorists to use their highways, such as “persuading” legislators to enact laws lowering the speed limits on public highways, adding unnecessary traffic lights and stop signs, and forbidding the widening of, or other improvements to, public highway alternatives to the privatized toll road.

Last month, I had the opportunity to see privatization, United Kingdom style, and privatization, France style. The difference in terms of highway conditions was notable, and as I drove I thought about the difference. In the United Kingdom, motorways for the most part are congested, even at times one would expect that not to be the case. During my ten days of driving, I often encountered stopped or crawling traffic in remote areas. Service areas exist, though in some places they are few and far between. Residents with whom I discussed the motorway situation complained that they expected to get more for their road tax dollars than they were getting. In contrast, motorways in France are congested for the most part only at the times and places one would expect. They are in such good condition that the speed limit is roughly 10 miles per hour higher than in the United Kingdom. Rest areas exist every ten kilometers or so, and service areas every 40 kilometers. Given the choice of which system I would want to use for a road trip, setting aside issues of destination and weather, I would select France.

I noticed two differences. First, in the United Kingdom, only a very small fraction of the motorway system is in the hands of the private sector. Second, the tolls in France, though high by American standards, are lower per-mile than the tolls charged on the few miles of United Kingdom motorways. An peek at what happened in the United Kingdom opens the door to understanding the differences. Because of severe congestion on one motorway, the United Kingdom government decided that a bypass needed to be constructed. Rather than building it with road tax funds, the government granted the construction rights to a private company that was permitted to charge tolls. What happened? The road was built, but the motorists didn’t show up. Motorists continued to use the severely congested motorway. Because of the insufficient revenue, the private company increased the tolls several times, and consequently road usage declined even more. I drove the toll road, out of curiosity and because my routing sent me that way. For a one-time use, I wasn’t very concerned about the toll. There was very little traffic on the toll road, and when it reconnected with the motorway it bypassed, traffic slowed to a crawl.

Though some Americans perceive France as the antithesis of the capitalistic ideal, its experience with motorways suggests that there are ways to rescue America from the highway infrastructure deterioration that threatens its economy and security, without selling out to the private sector. The history of highway privatization failures in the United States and in the United Kingdom suggests that there are some lessons to be learned in those nations.

Friday, September 13, 2013

Polishing Subchapter K: Part XX

The definition in section 753 of income in respect of a decedent refers only to section 736(a) payments. If section 736 is repealed, section 753, as presently structured, becomes meaningless. Section 753 does not define income in respect of a decedent, because there are other payments made in respect of a decedent partner that constitute income in respect of a decedent. Even if section 736 is not repealed, it makes no sense to characterize 736(a) payments as income in respect of a decedent. The portion of section 736(a) payments that would be characterized as income in respect of a decedent under the general income in respect of a decedent rules would remain so characterized. Any other portion of section 736(a) payments ought not be characterized as income in respect of a decedent. Thus, no matter what is done with respect to section 736, section 753 ought to be repealed.

Wednesday, September 11, 2013

Polishing Subchapter K: Part XIX

If section 736 is the most criticized provision in subchapter K, the anti-abuse regulations might be the most criticized regulations under subchapter K. The criticism extends not only to the substance of the regulations but also to the authority of the Treasury to issue them. With the enactment of the section 7701(o) economic substance provision, the need for the anti-abuse regulations is even less than whatever it may have been at the outset. In just about every ruling and judicial decision in which the anti-abuse regulations were invoked as a reason for the conclusion, alternative grounds under other provisions also were set forth. Repeal of the anti-abuse regulations would be an improvement.

Monday, September 09, 2013

Polishing Subchapter K: Part XVIII

Section 708 provides that a partnership terminates for federal income tax purposes if “within a 12-month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits.” The consequences of a termination of a partnership by reason of sale of a partnership interest are for all intents and purposes negligible. Because of the seven-year time periods in sections 704(c)(1)(B) and 737, the regulations were amended to provide that the terminated partnership transfers its assets to a new partnership, which is an impossibility because the new partnership cannot have just the old partnership as a sole partner. The old partnership is then treated as transferring the interests in the new partnership to the new group of partners, another impossibility because the old partnership cannot have multiple interests in the new partnership. The new partnership ends up with the same assets, adjusted bases in its assets, and other attributes as were held by the old partnership. Considering that large partnerships that qualify for the special rules in sections 771 through 777 do not terminate on account of sales of interests, there is no need to terminate any partnership on account of sales of interests, and particularly no need to engage in a sequence of impossible transactions that amounts to nothing more than a charade that in effect keeps the terminated partnership, for all intents and purposes, in existence.

Friday, September 06, 2013

Polishing Subchapter K: Part XVII

Section 736 is one of the most frequently criticized provisions in subchapter K. Proposals for its repeal have been in place for decades. It is difficult to get across to students the fact that section 736 does not provide for substantive outcomes but merely separates liquidating distribution payments into segments, each of which is subject to different provisions elsewhere in subchapter K. The regulations under section 736 provide rules to deal with liquidating distribution payments received over multiple years, but those situations ought to be subjected to the provisions applicable to installment sales.

Considering the extensive explanations provided by advocates of repealing section 736, there is no need to duplicate those efforts. Suffice it to say that section 736 is a maze of exceptions, exceptions to exceptions, and exceptions to exceptions to exceptions, is a trap for the unwary who do not realize there are opportunities to affect the outcomes by putting goodwill provisions into the partnership agreement, and adds layers of unnecessary complexity to the taxation of partnerships.

Wednesday, September 04, 2013

Polishing Subchapter K: Part XVI

The provisions in section 724 that retain the character of gain or loss in unrealized receivables, inventory, and depreciated capital assets contributed to a partnership, and the provisions in section 735 that retain the character of gain or loss in unrealized receivables and inventory distributed by a partnership, apply not only to those items but also, under section 724(d)(3) and section 735(c)(2) to substituted basis property. In other words, if the partnership or partner exchanges the property and the adjusted basis in the replacement property reflects in whole or in part the adjusted basis in the exchanged property, sections 724 and 735(a) apply to the replacement property.

In contrast, if the partnership or partner transfers the property to another person under circumstances that cause the other person to obtain a transferred basis in the property, sections 724 and 735(a) do not apply. In other words, if a partner, for example, transfers distributed inventory by gift to a another person, the other person holds the property as an investment and subsequently disposes of the property within the five-year property, section 735(a)(2) does not apply. The other person’s gain would be capital gain, not ordinary income. For sections 724 and 735(a) to be fully effective, they need to apply not only to substituted basis property but also to transferees with transferred basis in the property.

Monday, September 02, 2013

Polishing Subchapter K: Part XV

Sections 724(a) and (b) and 735(a)(1) and (2) apply to retain the original character of not only the inherent gain or loss in property contributed to, or distributed from, a partnership, but also any gain or loss arising from changes in value after the contribution or distribution. In contrast, section 724(c) applies to retain the original character only of the inherent capital loss in a capital asset contributed to a partnership. That approach makes more sense in light of the purpose of these provisions, which is to prevent manipulation of the character of the inherent gain or loss. Gain or loss arising after the contribution or distribution does not exist at the time of the transaction and thus is not something in the hands of the partner or partnership to attempt to recharacterized. In other words, the reasoning behind the limitation in section 724(c) should apply to sections 724(a) and (b), 735(a)(1) and (2), and the proposed section 735(a)(3).